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Optimal capital structure and investment decisions under time-inconsistent preferences

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  • Tian, Yuan

Abstract

Based on a continuous-time model of quasi-hyperbolic discounting, this paper provides an analytically tractable framework of entrepreneurial firms׳ capital structure and investment decisions under time-inconsistent preferences. Inefficiency in both investment and default is caused due to time inconsistency, if we view the time-consistent benchmark as efficient. Compared to the standard trade-off theory in corporate finance, we clarify that debt financing under time-inconsistent preferences brings a new trade-off between the alleviation effect on investment inefficiency and the aggravation effect on default inefficiency. The impact of time-inconsistent preferences depends on the entrepreneurs׳ belief regarding their future time-inconsistent behavior (i.e., sophisticated or naive). Concretely, we find that naive entrepreneurs always choose higher leverages, while sophisticated ones are more likely to choose lower leverages, compared to the time-consistent benchmark. Therefore, time inconsistency can explain the observed leverage puzzle (i.e., why firms choose different leverages even with similar fundamentals). Moreover, we demonstrate that time-inconsistent preferences delay investment and hasten default, due to the interaction among the three effects: option value effect, payoff value effect, and leverage effect. In particular, naive entrepreneurs invest later and default earlier than sophisticated ones, leading to a shorter operating period. These results support the empirical findings in entrepreneurial finance.

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  • Tian, Yuan, 2016. "Optimal capital structure and investment decisions under time-inconsistent preferences," Journal of Economic Dynamics and Control, Elsevier, vol. 65(C), pages 83-104.
    • Handle: RePEc:eee:dyncon:v:65:y:2016:i:c:p:83-104
    DOI: 10.1016/j.jedc.2016.02.001
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    6. Yanzhao Li & Ju'e Guo & Yongwu Li & Xu Zhang, 2021. "Optimal exit decision of venture capital under time-inconsistent preferences," Papers 2103.11557, arXiv.org.
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    13. Gan, Liu & Xia, Xin & Chen, Yifei, 2018. "Investment and financing choices by time-inconsistent managers," The North American Journal of Economics and Finance, Elsevier, vol. 46(C), pages 29-48.
    14. Gan, Liu & Xia, Xin & Xu, Mingyu, 2023. "Entrepreneurial investment and financing with third-party guarantees under present-biased preferences," Finance Research Letters, Elsevier, vol. 55(PA).
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    More about this item

    Keywords

    Capital structure; Investment; Default; Quasi-hyperbolic discounting; Time inconsistency;
    All these keywords.

    JEL classification:

    • D92 - Microeconomics - - Micro-Based Behavioral Economics - - - Intertemporal Firm Choice, Investment, Capacity, and Financing
    • G02 - Financial Economics - - General - - - Behavioral Finance: Underlying Principles
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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